The basic rule in retirement planning is to start saving as soon as you can. Ideally, you'd start saving in your 20s, because the sooner you begin saving, the more time your money has to grow. Each year's gains can generate their own gains the next year through a powerful wealth-building phenomenon known as compounding.
Retirement savings options
401(k)s and similar plans such as 403(b)s, 457s and Thrift Savings Plans are ways to save for your retirement that your employer provides or sponsors. They are also known as "defined contribution plans." That name comes from the fact that you make contributions to the plans. In other words, you put your own money into them and your employer matches your investment on a percentage basis or 100%.
401(k) plans are the most common type of defined contribution plan, so that is why you hear about most it most often. But in reality there are no huge differences between a 401(k) plan and the other defined contribution plans, beyond who can use them, of course. For more information speak with your employer’s plan administrator.
Annuities
An annuity is an insurance product that pays out income. It can be used as part of a retirement strategy. Annuities are a favorite choice for investors who want to receive a steady income once they retire.
You start by making an investment in the annuity. It then makes payments to you on a future date or dates. The income you receive from an annuity can be paid out monthly, quarterly, annually or even in a lump sum payment.
The size of your annuity payments are determined by a variety of factors such as the length of your payment period. You can opt to receive payments for the rest of your life or for a fixed number of years. How much you receive depends on whether you opt for:
- Fixed annuity: A guaranteed payout.
- Variable annuity: Payout stream determined by the performance of your annuity's underlying investments.
Anyone considering an annuity should research it thoroughly first, before deciding whether it's the appropriate investment. Annuities can be useful retirement planning tools but they can also be a poor investment choice for some people because of their high expenses.
IRAs
IRA, also referred to as an Individual Retirement Account, is basically a savings account with big tax breaks. This makes it an ideal way to store cash away for your retirement. Many people erroneously think an IRA itself is an investment, but it's just the basket in which you keep stocks, bonds, mutual funds and other assets.
IRAs are accounts that you open on your own, unlike 401(k)s that are sponsored by your employer. They are opened by self-employed individuals and small business owners. There are several different types of IRAs:
- Traditional IRAs
- Roth IRAs
- SEP IRAs
- Simple IRAs
Each IRA has eligibility restrictions based on your income or employment status. And all have caps on how much you can contribute each year and penalties if you pull out your money before the determined retirement age. Contact your preferred financial institution for more information on the pros and cons of each IRA.
Self-employment plans
The good news for self-employed individuals is that there are many but the challenge is figuring out which of the major plans best suits your needs. The most common retirement accounts for the self-employed are SEP IRAs, Simple IRAs and individual 401(k)s.
These plans have up-front tax breaks and tax-deferred saving, meaning you don't pay taxes until you withdraw the money in retirement, the exception being the Roth version of the individual 401(k). You don't get an up-front tax break, but your money not only grows tax free and withdrawals in retirement are also tax-free.
Pension plan
A pension plan is a retirement account for which your employer does all the work. The employer puts up the money and decides where to invest it. A pension promises you a set payout when you retire, determined by your salary and how many years you worked for the employer. There are two basic kinds of defined benefit plans: pensions and cash-balance plans. Most employer sponsored plans require that you be employed for a minimum of one year. You also need to stick around on the job for several years, typically five, to be fully "vested" in the plan. If you leave before then, you may forfeit any unvested pension benefits.
Social Security
A financial safety net for retirees, Social Security was established in 1935 by the Social Security Act. The program is based on contributions that you make into the system. While you're employed, you pay into Social Security through Federal Insurance Contributions Act (FICA) taxes that are withheld from your paycheck or earnings if you are self-employed. You receive benefits when you retire.
Your monthly benefit depends on average earnings during a lifetime of work. The amount may also be affected depending on your age when you start getting social security. For example, if you start collecting social security payments before age 65 (or 67 in some cases) your monthly benefits will be lower until you reach your required retirement age. Medicare benefits are also considered part of Social Security benefits, although technically Medicare is a separate program. For an estimate of your Social Security benefits and more information visit www.ssa.gov.
Estate planning
Estate planning helps you decide how you want your assets distributed after you die or become incapacitated. Estate planning can be complicated, so it's best to consult both a financial adviser and an estate lawyer when drawing up your estate plan. It's important to have a basic estate plan in place regardless of your net worth. Although it may seem like an unpleasant or morbid task, estate planning offers several benefits:
- You get to choose the people to whom you wish to leave your assets. This makes your wishes legally binding.
- You can arrange it so that you reduce as many taxes possible from your estate.
- You have the satisfaction of knowing that your financial affairs are in order. This will help avoid a costly administrative nightmare to your loved ones.
The typical estate plan includes elements such as:
- A will.
- Assignment of power of attorney.
- A living will, which is a statement of your wishes for the kind of life-sustaining medical intervention you do or do not desire in the event that you become incapacitated and unable to communicate your wishes.
- A healthcare proxy, which authorizes someone you trust to make medical decisions on your behalf.
- A living trust.